Did Capital Gains Taxes Cause The Market Fall?

April 24, 2000

In one of the more intriguing explanations for the recent stock market roller coaster, Wall Street investment adviser Jude Wanniski alerted his clients on March 30 that many stock sales appeared to be motivated by investors needing cash to pay their tax bills on capital gains realized last year during the NASDAQ market's huge run-up. The value of the NASDAQ market rose by an astounding 100 percent in 1999, from $2.6 trillion to $5.2 trillion.

An important factor contributing to investors' tax bills is the growth of capital gains distributions from mutual funds. Normally, capital gains taxes are only paid when a gain is realized by the sale of shares. But mutual fund buyers often have capital gains attributed to them when fund managers sell stocks.

Data from the Investment Company Institute show capital gains distributions have become important:

In 1990, capital gains distributions amounted to just $8 billion.

By last year, they had risen to $238 billion.

One-fourth of the unexpected surge in federal income taxes between 1996 and 1998 is attributable to capital gains distributions, according to an October 1999 Congressional Budget Office study.

Of course, not all distributions are taxable, since many mutual fund accounts are tax exempt. Still, at least 40 percent of distributions are taxed, according to the CBO. That would put taxable distributions at $95 billion in 1999. With the average tax rate on capital gains at about 25 percent, this suggests investors needed about $24 billion just to meet their federal tax bill.

The market's rebound on April 17 lends strong support to the "April effect" thesis. Congress should allow mutual fund investors to defer taxes on capital gains distributions and pay only when they actually sell their shares.